Past Performance No Guarantee
It’s truly amazing how new investors pick investments based upon short term past performance. Honestly, it is not that difficult to understand why new and seasoned investors make choices the way they do. All investors are under constant media bombardment touting various investments and how well they have performed. The financial media constantly releases new lists of best performing mutual funds as this is how they profit. Would you pick up a financial magazine if it had nothing new to offer? Unfortunately for the unwary investor these lists are cherry picked and selected for there recent out performance.
Past mutual fund out performance is no guarantee of future out performance. In fact usually just the opposite happens. For instance, in the late 1990s technology stocks and their related mutual funds outperformed just about every other sector. Had an investor put money into one of these funds they would have lost dearly. As it happens the best performing funds are usually in the sector that has experienced excellent recent performance. Eventually however the outperforming sector will correct it self and some other asset class will dominate.
The chart below displays the best and worst performing asset classes by year.
| Year | Best | Worst |
|---|---|---|
| 1994 | International | Bonds |
| 1995 | Large Cap | International |
| 1996 | Large Cap | Bonds |
| 1997 | Large Cap | International |
| 1998 | Large Cap | Small Cap Value |
| 1999 | Small Cap Growth | Small Cap Value |
| 2000 | Small Cap Value | Small Cap Growth |
| 2001 | Small Cap Value | International |
| 2002 | Bonds | Small Cap Growth |
| 2003 | Small Cap Growth | Bonds |
| 2004 | Small Cap Growth | Bonds |
| 2005 | International | Bonds |
| 2006 | International | Bonds |
| 2007 | International | Small Cap Value |
Large Cap = S&P 500 Index
Small Cap Value = Russell 2000 Value Index
Small Cap Growth = Russell 2000 Growth Index
International = MSCI EAFE
As you can see from the chart above any given asset class does not outperform for very long. Generally an asset class with outperform for a year or two and then become mediocre or terrible. Unfortunately for investors just as a specific sector has done well the media starts to pounce on it. They create there best performing list and the naive investor thinks the funds listed would be the best investment. Of course the investor inadvertently buys the mutual fund at the top and underperforms the market for many years.
It even gets worse when you consider that investors picking mutual funds based upon past performance are unwittingly picking an actively managed mutual fund. By there very nature active mutual funds will either outperform or under perform the indexes. The indexes on the other hand are seldom in the top performing lists over short periods of time. Indexes also do not end up on the bottom of the list but somewhere in the middle. As we know actively managed mutual funds over the long haul do not beat the indexes when including expense ratios and the extra taxes you get to pay.
Not even the mutual fund rating services are able to consistently pick winning funds in advance. Morningstar is perhaps one of the best rating services and has huge databases of mutual fund information. They developed what is known as the star system to rank mutual funds on how well they have performed. The media has picked up on the star system and so has the advertising agencies for the mutual funds. The star system has become a marketing tool even though Morningstar proclaims the system can not predict future performance.
If you are still not convinced that past performance is no guarantee of future performance consider the study that Vanguard conducted. Vanguards goal was to see if past performance has any bearing the future performance of a mutual fund. The study found that out of the top 20 US equity funds from 1983 – 1993, only one stayed in the top 100 from 1994-2004.